Sunday, April 1, 2012

The Myth of the Inflation Tax

Last time we looked at inflation as a "tax' from the incomes perspective. We established that the devaluation of the dollar (i.e: price inflation) over the last century is completely irrelevant, as average incomes have vastly beaten inflation.  So in short, Ron Paul's diatribes, that the sky is falling, the dollar lost 95% of its value, while technically correct, is very deceptive.  He conveniently ignores the fact that average incomes have vastly beaten inflation [1].

Along the same vein is the Paul's claim that inflation is a "tax" on savings. That would be a valid point, if we lived in a parallel universe where everybody holds most of their savings in cash.  Clearly we don't, but let us look at actual data for verification.

A recent academic study looked at the wealth distribution of Americans from 1983-2007 (pdf). Let us look at the non-home net wealth distribution (mostly financial) during the period (see page 46).  You see four distinct classes. First, the bottom 40% with an average net non-home wealth of -$10,500 (yes negative). Then, the 3rd quintile (40-60 percentile) with little net non-home wealth on average (just $26,500). Then, there is the 4th quintile (60-80 percentile) with a modest $135,700 on average. And finally, we have the top quintile with an average non-home net wealth of $1,863,600.

Paul's argument is completely irrelevant for those bottom 40%, who have no savings. They live paycheck to paycheck. A little inflation, will actually help reduce their debt burden. Thus real income gains are what matters to these folks. I will cover, in the next section, why is it they have no savings. For the top 3 quintiles, their non-home investments beat inflation on average by 122%, 87% and 66% over 24 years. Even the 3rd quintile who had no REAL (i.e adjusted for inflation) income gains in the same period, gained 66% in their financial investments. I will grant you, this was in 2007 before the financial crisis. By 2012, average cumulative returns were cut by 25%. They still beat inflation. The point is that, real people, who have actual savings are clearly NOT holding 100% cash.  If they were, the average REAL return would have been negative 52%. 

In reality, as of 2007 the average American held just 6.6% in liquid assets, (see pg.47). This study doesn't break down how much of these liquid assets were held in cash.  Fortunately, the Fed flow of funds (FOF) does break it down.  See Table B.100 line 11 (pdf).  Currency and checking accounts amount to just 0.11% of total household assets in 2007 [2].  Even in Q4 2011, it is still only 0.42% (of total assets).  Besides, the "liquid assets" category in the study includes money markets funds, online savings accounts and CD's.  And even they beat inflation when the target Fed Funds Rate (FFR) is a real rate (i.e set above inflation).  And you can see from this chart, normally the FFR is indeed set to a positive real rate.  Before the FFR rate cuts in late 2007, CDs, and even online savings accounts beat inflation.

So to say that inflation is a tax on savings is outright propaganda.  Not on actual savings of real Americans.  Clearly real Americans are not stuffing cash into mattresses.  When the FFR is set to a positive real rate, as it usually is, even grandmothers can beat inflation [3]. 

The Real Tax on Savings

You know what is really a tax on savings, bank engineered financial crises.  The average American lost 25% of their total net wealth due to the Great recession of 2007. Some of the lower quintiles lost as much 50% of their net wealth, as more of their wealth is tied up in their homes. Now, that is the real tax on savings. During the 50 years from the mid 1930s to the mid 80s, there were no significant financial crises, as banks were tightly collared. There were a few mild recessions, but not a single one was due to a financial crisis [4].

But is Paul for collaring banks? No, he wants them to be even more free. He wants to take us back to the 19th century era of free banking. This was a time, when there were financial panics every 2 years. I am not kidding... On average, from 1836-1929 there was literally a recession 2 years after the end of the previous one. And most of them were caused by financial panics. A total of 19 recessions and 5 depressions including the Great Depression [5]. This was time when many people actually kept their money in mattress, because if they kept it in a bank, their savings along with the bank could go poof one day [6].  Talk about a tax on saving, but apparently that's okay because banks are free...

Wonder why is it that the bottom 40% don't have any savings? It wasn't always the case. During the New deal Era (1933-1973) average earned income of the bottom 90%, beat inflation by 405% (4.13%/yr), while during the market liberalization era (1979-2006) it was just 1.6% (0.059%/yr). Yes really, a cumulative 1.6% REAL income gain over 27 years [7].  Three decades of market liberalization, have transferred more and more income to the top 1% from the bottom 90%.

From 1979-2006 the top 1% captured 62.5% of the average REAL income gains. The top 5% captured 84.9%. On the other hand the bottom 90% captured just 4% in those 27 years!! In stark contrast, from 1933-1973 the bottom 90% captured 70.6% of the average real income gains [8]. It doesn't take a genius to figure out that the bottom 40% took the brunt of the upward income transfers since 1979. And wonder why they have no savings...

The real tax on savings is not inflation, it is under-regulated banking and excessive market liberalization.  But yet, Paul's supporters claim that he represents the interests of the average American.  If he was, he would be for tightly regulated banking, and rolling back three decades of market liberalization. But his actual views are diametrically opposite.  The bottom 90% fared vastly better during 1933-1973, when finance was tightly controlled, and top marginal taxes were high.  Hell, even the bottom half of the top 1% fared better back then.

Notes

1. Paul's claim is even more irrelevant, given that nominal average incomes should at least keep pace with inflation, as prices are income for producers.   Most consumers are also producers.  Your income derives from your role in the production of a good or service. But of course, it is true, income gains may not be distributed evenly. Obviously when there are real gains, incomes beat inflation.  Average incomes beat inflation by 230% from 1913-2006. 
2. While the Levy Institute study only includes households, the FOF table B.100, not only includes households, but also non-profit institutions and for some reason domestic hedge funds.  B.100 seems to be a "rest of" category, after taking into account corporations, banks etc:   So households themselves probably held more than 0.11% in cash and checking.  But it is definitely well below 6.6%.
3. Of course, if the  FFR is set to a negative real rate for a long time, average savings may (but not necessarily) fall behind inflation.  It may not as liquid assets are only 6.6% of total assets.  Homes are a big component of total assets, and a low FFR helps somewhat in that regard, enabling low mortgage rates. Mortgage rates are based on 10 yr treasuries, and 10yr  treasury bonds have never deviated more than +/- 4% from the FFR.  But, what is root cause for the target FFR to be set low right now?  Economic weakness due to the bank engineered financial crisis. The root cause is again under-regulated banking.
4. The recession of 1937 was the only severe recession during this period.  It was primarily due to FDR balancing the budget. But he quickly reverted and resumed even bigger deficit spending than before.  Thus recovery came quickly and the recession was over in about a year. From 1938-39 Real GDP increased 8.1%, 39-40: 8.8%,  40-41: 17.9%  etc:
5. Even though the creation of the Fed in 1913 ended the free-banking era, finance remained unregulated. That is why I am including the period after 1913.
6. This is one of the root causes of the Great Depression. 10,000 banks failed from 1929-1933. While that in itself is not a major issue, there was no deposit insurance back then. So when a bank failed, customers lost their savings, which led to further reductions in consumer spending, further steepening the recession. 
7.  All average earned income figures are in 2006 dollars. Keep in mind nominal income for bottom 90% increased by 163% from 1979-2006, prices rose 159% using CPI-U RS data set.  Thus average incomes beat inflation by just 1.6%.  Source: UC Berkley Table A4 based on IRS data
8.  Table A6 from same source above in 2006 dollars.  Table A4 excludes capital income,  A6 includes all income.  The same analysis can be found at this interactive chart from EPI.  Same UCB source but in 2008 dollars.